Monday, January 28, 2008

What is the purpose of a fiscal stimulus?

In the course of thinking about my last post, I have come to a striking realization: the (primary) purpose of a fiscal stimulus is not, as commonly believed, to stimulate aggregate demand and thereby increase economic activity; the purpose is to prevent interest rates from going down.

If the purpose of a fiscal stimulus were to stimulate aggregate demand and thereby increase economic activity, then a fiscal stimulus would almost never be a good idea. Typically, when a fiscal stimulus is proposed, one will hear arguments against it from various economists, typically of the more conservative-leaning variety (as, for example, Andrew Samwick here). These arguments rest on the premise that the conventional reason for a fiscal stimulus is the true reason. They argue (in my opinion) convincingly that that reason is not a good one, and they conclude that a fiscal stimulus is a bad idea. Essentially, anything that fiscal policy can do, monetary policy can do better. And monetary policy will do it, because that’s the job of central bankers. And if you disagree with the central bank about whether we need a stimulus, it will do you no good to try to use fiscal policy unilaterally, because the central bank will act to offset the effect with higher interest rates.

There is one exception – one case where monetary policy (maybe) just doesn’t work: that is the case where the interest rate is zero. In that case, there is no opportunity for the central bank to stimulate the economy by reducing interest rates. And if the central bank tries to stimulate the economy just by increasing bank reserves, this may be ineffective, because banks, having obtained the funds at zero cost, will feel little pressure to make loans; they may simply hold all the extra reserves as free insurance against the prospect of unexpected cash needs. And moreover, their creditworthy customers may not be willing to borrow, even at extremely low interest rates, if they can’t think of anything good to do with the money. This may or may not have happened in Japan; it’s still controversial whether the Bank of Japan’s policy of “quantitative easing” had a major impact. Anyhow, it’s something to worry about.

But in the US, for example, the interest rate has not been zero since 1938. So this one exception does not apply. If you’re worried (like Paul Krugman) that the exception might apply at some point in the not too distant future, then your argument about today is not that the exception does apply, but that we need to take action to avoid the situation in which the exception would apply. In other words, you don’t want interest rates to go too far down. You want a fiscal stimulus to prevent interest rates from going down.

Alternatively, let’s say that you were calling for a fiscal stimulus (or perhaps a larger or better directed one than what we actually got) in 2001 and 2002 and that you had the foresight to see that a monetary stimulus would affect the economy by producing an excessive and ultimately destructive housing boom. If your foresight were that good, you would probably have seen also that the monetary stimulus would succeed in getting the economy going and getting the unemployment rate down. So you couldn’t advocate a fiscal stimulus for that purpose, which would already be served. Rather, you would advocate a fiscal stimulus to avoid an excessive housing boom – by preventing interest rates from going down.

Today it would be hard to argue that a monetary stimulus could spark another excessive housing boom. (It might, I think, spark some kind of a boom, but the boom will be more orderly and rational, given the “once bitten” status of the housing market, as well as the elimination of many of the prospects for creative financing.) But a monetary stimulus could have another bad effect – rising import prices due to sudden drop in the dollar. The way to avoid that effect is to keep US interest rates high enough to attract capital from abroad, which will prop up the dollar. And the way to do that is with fiscal policy – a policy to produce a demand for that capital, so that someone in the US will be willing to pay those interest rates. Again, the purpose of a fiscal stimulus is to prevent interest rates from going down.

[Update: pgl's response at Angry Bear makes me realize that my reference to "another bad effect – rising import prices" was misleading. Rising import prices are a good thing, in my opinion, in that they would help reduce the international imbalance (the large net inflow of goods to the US from Asia), but on balance, only a good thing if the prices rise slowly enough to avoid a dramatic deterioration of the output-inflation tradeoff (i.e. stagflation, or something like it). The argument for using a fiscal stimulus, and therefore having relatively higher interest rates, today is that higher rates would let the dollar fall gradually, thereby avoiding the shock from a sudden deterioration in the terms of trade. It would also avoid a sudden contractionary shock to the rest of the world's economy.]

27 Comments:

I'm glad you are still thinking about this topic, it's too bad we haven't gotten others involved in the discussion so far.

My take on the goals of the Fed is somewhat different. I see their goals as protecting the interests of the rentier class. I think Greenspan and Volcker were quite explicit about this, I don't know about the current mindset.

The rentier class only fears one thing: inflation. If interest rates are fairly stable over the long term I can be relatively certain of what my income will be, but if inflation increases then I have a permanent decline in the value of my capital. This is difficult to recover from.

The other stated mandate of the Fed is to maximize employment, but they have never tried to meet this objective. In fact it is at odds with promoting economic "growth". So Volcker was willing to cause a huge increase in unemployment to bring down the inflation.

Most working people were not adversely affected by the inflation of the period. Those with mortgages got a bonus, those who worked in unionized jobs (or industries which followed union's leads) tended to see their pay rise almost as fast as the inflation.

Since workers have little in the way of fixed interest assets the decline in their real value was not an issue. It was an issue to the coupon-clipping set and these are the ones that Volcker was aiding.

We now face a situation similar to the 1970's. We refused to pay for the war while it was raging and the consequence was the need to print money later to make up the shortfall. Raising taxes is never the primary approach of politicians.

So we have a conflict between the politicians who like printing money and the Fed who likes protecting the rentier class by weakening the working class. I don't see why the dynamics this time should be any different.

George Washington wrote to the first congress in despair over the huge debt outstanding from the Revolutionary War. He saw no way to pay it down. It was $1 million. Inflation took care of it, just like it has all other deficits caused by uncontrolled militarism.

I see a huge difference between today and the 1970s in that the labor market was booming during much of the 1970s and is quiescent today. Even though the unemployment rate was higher in the 1970s, there were a lot of new jobs being created, and there was upward pressure on wages. Today one would certainly not want to use the help wanted section of the paper as a cushion.

It seems to me monetary policy would be more effective when interest rates are very low. To a large extent it works by changing the discounted value of the stream of returns from long-lived assets. As interest rates approach zero, the effect of a given change in the interest rate on the value of the stream approaches infinity. Of course the Fed is not in a position to reduce the relevant interest rates to zero, since they include risk premia, etc., but, one can imagine that the relevant interest rate is a rate the Fed controls plus a fixed risk premium. In that case the cut from, say 0.5% to 0 should be much more powerful than the cut from, say 4.5% to 4%.

I'm not sure of the intent of your comment about workers having more bargaining power in the 1970's. I'm sure this is true. Are you implying that the Fed now has more concern for workers since they won't be able to keep up with inflation?

So they have gone from protecting those with fixed yield assets to the ordinary worker? Do you have any evidence for this?

As for rising imports being a "good thing". This seems to be only the case if one looks at only one side of the equation. It may be a good thing if we bring down the foreign trade deficit, but rising prices are a bad thing for consumers, especially if you believe that they have little ability to force their wages higher due to lack of organizational strength.

Sure I can skip buying a new TV, but what do I do about all the essentials that are only available as imports? People clothed in tatters is not a sight to be hoped for. We can no longer substitute domestic production for a wide range of products.

And while everyone seems to be willing to discuss cutting down on demand by ordinary buyers there is no discussion of the effect the half trillion military budget has on the economy. Building bombs and blowing them up doesn't provide much in the way of follow on economic stimulation.

Notice how "compassionate" conservatives are always eager to cut social services because they (allegedly) have a negative impact on the budget, but are mute when it comes to militarism.

I know everyone is concerned with the best short term "stimulus" package, but I think this is a side show which keeps people from examining the structural defects in the current economy.

Resource prices will continue to rise and so will goods that use them as inputs. We have had no discussions as to how this is going to be handled. The optimists appeal to technology as some sort of magic bullet, or say Malthus was wrong before so by historical analogy there is nothing to worry about this time.

Wishing won't make it so. We need some realist long-range planning and an industrial policy.

The weakness of labor means that deflation is a real possibility, since energy and commodity prices could reverse dramatically in a recession, and competition could drive firms to cut prices and wages without effective resistance from their workers. It also means that a 1970s-style inflationary spiral need not be a concern, because workers are not in a position to demand that their wages keep up with the cost of living.

Given that the Fed wants to avoid deflation (which has surely been true under both Greenspan and Bernanke, and explains why money was so easy in 2003), and given that their concerns about inflation are limited, we can expect that the Fed will make diligent attempts to avoid a (potentially deflationary) recession, and we can also expect that the inflation rate will not go as high as it did during the 70s.

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